Inside the analysts' room – How the pros connect the dots

It's not what you know but what you do with that information that counts.

The pros all have access to the same information, says this portfolio manager, but that doesn’t mean they all make the same decisions.

In a sense, there is no such thing as inside information in investing. Or to put it another way, it’s not what you know but what you do with that information that counts.

Let’s get the professional point of view from Mr. Peter Hodson, senior portfolio manager of the Sprott Growth Fund. Recently, he took readers of Investor’s Digest of Canada inside an investment “war room.”

He explains how his investment group came to certain conclusions on key issues and specific investments, how they “connected the dots” in order to reach their decisions.

“However, in our daily meeting,” says Mr. Hodson, “we stress it is often not what you read that’s important, it’s the dots. As investment managers, we know everyone in our business sees the same headlines and press releases. Strong portfolio managers, however, go behind the headlines and look at how they can connect the dots to reach an investment conclusion.”

It’s really quite simple, says this portfolio manager. But investors “can miss the connections because they are bogged down by the overall noise in the market.”

Here are just a few examples of how it’s done.

Coal plummets!

In the first week in July, the price of coal plummeted across the world for one day. The next move was easy to predict, says Mr. Hodson. “Coal equities – taking their cue from the commodity – fell off the cliff.” Some shares trading for $11 on Friday were cut in half by Tuesday.

But wait. During the panic, these analysts noted one interesting comment from China. The government had suspended operations at several power plants due to a shortage of thermal coal.

“We watched in disbelief as the prices of coal stocks kept falling even after this announcement,” says the portfolio manager. “We kept buying, as the dot-connecting game doesn’t get much better than this.

“We have, effectively, the fastest-growing economy in the world telling us that it has run out of coal. Note, not ‘running out’ but ‘run out’ to the extent that power plants needed to be shut down. Connecting the dots here certainly implies that the run-up in coal prices might not be over soon.”

Short in Ford

On the other hand, a red flag went up at Ford Motor Co. (NYSE: F, Stock Forum). In June, Mr. Kirk Kerkorian’s Tracinda Corp. offered to buy 20 million shares of the automaker at $8.50 a share.

When it came time to tender, shareholders possessing more than one billion shares tried to sell to Tracinda. “What a giant dot!” says Mr. Hodson. “When more than half of your company’s shareholders want to exit their position, it is generally not a good sign of shareholder confidence in the company.”

So, despite Tracinda’s offer, there did not appear to be much hope for a sudden run-up in Ford’s shares. Mr. Hodson and his colleagues kept their short position in Ford and saw the shares fall 27% following the tender offer – and almost 50% over the past year.

A bullet in the head

The U.S. economy is in trouble. This is certainly not news. But it does mean you must be wary of certain news releases. Like those of the U.S. Federal Reserve Board.

With the financial system getting flushed out, housing in a state of collapse, and bankruptcies piling up, things are not about to get better, says this portfolio manager. “Oh yes,” he adds, “I forgot about the fact that the U.S. is fighting two wars and running up a huge spending deficit.”

But the Fed goes on and on about inflation and how it may have to raise interest rates to fight rising prices. Connect the dots, says Mr. Hodson, and you’ll see that it’s not likely.

“A rate hike at this time would be like putting a bullet into the head of an already beaten-up, overleveraged, stressed-out U.S. consumer or homeowner,” he says. It would be a death knell for the U.S. economy. Don’t expect it to happen.

Closing the hedge book

Finally, there is the great Canadian concern – commodities. Mr. Hodson and his colleagues have read many stories of mining projects being shelved. Financing is simply not available for many large-scale projects that require billions in capital.

All of this points to a tightening of commodity supply in the future, which can also spell opportunity. The commodities boom may not have run its course, although many headlines insist that it has.

“Sometimes, connecting the dots can be so simple that you, at first, don’t believe it is not obvious to everyone,” says Mr. Hodson. “This is the fun part of dot connecting. Sometimes, investors look for hidden meanings behind headlines and think too much. This can result in overtrading and style shifts at inopportune times.”

Think carefully before you decide how to act, says Mr. Hodson. He has one more example for his Investor’s Digest readers. Recently, a company he follows, Century Aluminum (NASDAQ: CENX, Stock Forum) decided to unwind all of its hedged position in aluminum. Its low-priced contracts blocked it from taking advantage of current high prices.

The dot to connect? This $2.5 billion company spent $1.7 billion to cancel its hedge book. This represents a massive bet that aluminum prices will keep going up.

“Now I don’t know if the company will be right or wrong on this call,” says Mr. Hodson, “but I do know this: Century knows a lot more about aluminum and its potential customer demands than you or I do.”

In fact, the price of aluminum has been down the last week or so, and Century’s price chart looks a bit ragged (like that of many stocks these days) but has had an upturn of late. So the jury is still out on this one.

But the point of the exercise is clear. Don’t let the headlines push you through the stock market. Look for simple, logical clues, connect the dots, and you may profit from an opportunity that thousands miss.